Drain of USD liquidity could squeeze US$11t debt

The key lines of defence have held on Wall Street. The S&P 500 index bounced off its 200-day moving average at the end of last week’s brutal sell-off, triggering a surge of buying by well-armed funds waiting for the technical signal.

Relief comes in the nick of time. The 10.2 per cent crash was starting to infect credit, the mechanism that can so easily cause what looks at first like a “healthy correction” to metastasise into an economic downturn. Borrowing costs on BBBrated corporate debt in the United States have surged by 57 basis points to a 14-month high of 6.26 per cent since late January.

Credit default swaps measuring bankruptcy risk for junk bonds spiked on Friday to 356 after having weathered the first phase of the rout relatively untouched. This was becoming ugly for stretched debtors — potentially 20 per cent of the US corporate universe, says the International Monetary Fund — with California Resources seeing its yield spiralling up to 14 per cent, and Community Health hitting 21 per cent.

Marc Ostwald, a credit expert at ADM, says heavy withdrawals from exchange-traded bonds threaten to set off a self-feeding process.

There have been several episodes over the last century where stocks have rolled over under their own weight after a euphoric boom, causing a recession even though the growth was robust and the horizon looked clear.

“It was not the economy that dragged down equities in 2000, it was the market moving first and dragging down the economy,” said Matt King, credit strategist at Citigroup.

Nobel economist Robert Shiller, a historian of bubbles and author of Irrational Exuberance, said US consumer sentiment mysteriously peaked in January 2000 during the dotcom blow-off and then went into a relentless slide.

“I still don’t really understand why. I have been thinking a lot about whether we might see the same thing now,” he told The Daily Telegraph.

For the time being, today’s bull market is probably still intact, although market veterans say it must hold on its current line or else crumble in a panic slide to much more menacing levels. The wild selloff was essentially an unwinding of “short volatility”, a niche trade where you bet on perpetual and anomalous calm, leveraged to the hilt by taking extreme risks on the options markets.

The bizarre episode shows just how much zero rates and asset purchases by central banks have distorted the global financial system. What is unsettling is how little it took to puncture this balloon. All it required was a whiff of wage inflation and a 40-point jump in the global price of money — a 10-year US Treasury bond — to 2.85 per cent.

Markets may yet test the level of the “Fed Put”, probing to see how much pain will be tolerated under the new regime of Jay Powell. “Markets stop panicking when central banks start panicking,” said Michael Hartnett from Bank of America.

We are nowhere near that threshold.

“Small potatoes,” was the insouciant verdict of New York Fed chief Bill Dudley after the crash, eager to dispel any notion that the authorities will bail out speculators. “If the stock market were to go down precipitously and stay down, then that would feed into the economic outlook, and that would affect my view for monetary policy,” he said.

The sudden shake-out this month is best understood as an early warning tremor.

It is a sign of how sensitive the world has become to a turn in the interest rate cycle, a dangerous inflexion point now that debt ratios have risen by 51 percentage points since the peak of the last bubble to a record 327 per cent of GDP.

The whole edifice of global asset prices is built on the perilous assumption that central banks can and will hold down the cost of borrowing for years to come, and that communist China knows what it is doing as it issues 70 per cent of all new loans in the world.

The most treacherous feature of this is that central bankers themselves cannot easily judge the potency of monetary tightening as QE is unwound, since it has never been done before. Former Fed chief Ben Bernanke strongly advised his old colleagues to leave the Fed balance sheet well alone and avoid such a fateful experiment altogether.

The flow of QE from the ECB and Fed together will have gone from plus US$100bn a month in late 2016 to minus US$50bn by the end of this year, a net reversal of US$150bn. The central banks have models for what this means for bond yields — not much — but largely neglect the effects on the money supply. It is the latter that disturbs monetarists.

Growth of the real M1 and M2/M3 aggregates has slowed to varying degrees in the US, Europe, and China, pointing to an economic slowdown within nine months to a year that would — if it happens — come as a very nasty shock.

The US monetary base has been contracting at an annual rate of 6.1 per cent over the last three months, according to CrossBorderCapital. This is slowly draining global dollar liquidity, raising the risk of a future squeeze on the offshore dollar funding markets and the US$11 trillion nexus of loans issued in dollars beyond American jurisdiction.

The huge relief over the last week is that the stock market crash did not trigger any safe-haven flight towards the dollar or set in motion a worldwide scramble for Greenbacks.

The needle barely moved on the dollar index (DXY). As long as that remains the case, the bull market is alive and well.

Think of it as a vast global “short position” on the dollar that was pushed to unprecedented proportions by worldwide leakage from US zero rates and QE. It would be a miracle if monetary tightening by the Fed does not at some point set off a global “margin call” of equal scale. Elastic snaps back.